An investor holding a portfolio of long-term U.S. Treasury bonds observes a significant decrease in the market value of the bonds following a series of interest rate hikes by the Federal Reserve. The investor is concerned that the U.S. government's ability to pay interest has deteriorated. Which statement accurately identifies the risk factor responsible for this price decline and its core characteristic?
- The decline is caused by interest rate risk, a systematic risk that inversely impacts bond prices when market rates rise, independent of issuer credit quality.Answer
- BThe decline is caused by default risk, which can be eliminated by expanding the portfolio to include long-term corporate bonds across multiple industries.
- CThe decline is caused by interest rate risk, but it can be completely eliminated by diversifying into a broader selection of long-term debt securities.
- DThe decline is caused by an inverted yield curve, which signals an immediate rise in issuer default rates during periods of rapid economic expansion.
Answer
The decline is caused by interest rate risk, a systematic risk that inversely impacts bond prices when market rates rise, independent of issuer credit quality.
When prevailing interest rates increase, the prices of existing fixed-income debt instruments fall to align their yields with newly issued bonds. This inverse relationship represents interest rate risk, which is a systematic risk inherent to fixed-income investing and applies even to default-free obligations such as U.S. Treasury bonds.
Step-by-Step Solution
Key Concept
Interest Rate Risk as a Systematic Risk
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